Investors facing a “nasty cocktail” as stagflation looms

Robert Alster, chief investment officer at Close Brothers Asset Management says: “The US Federal Reserve’s Open Markets Committee (FOMC) voted last week to leave interest rates unchanged.

"The decision to keep the upper bound at 5.5 per cent was widely anticipated but, the committee surprised markets by delivering a more hawkish message than had been expected.

Firstly, FOMC members’ forecasts of where rates will be, known as the “dot plot”, shifted higher. The dot plot now indicates one more hike in 2023, with rates ending 2024 at 5.125 per cent, 2025 at 3.875 per cent and 2026 at 2.875 per cent.”

Alster says this represents a shift higher compared to the last set of forecasts, and suggests that rate cuts will happen only very slowly.

"The Fed’s GDP forecasts also improved, with no marked slowdown in growth now expected," he added.

"The market reaction to the announcement was negative, reflecting the fact that monetary policy is likely to remain restrictive for longer than markets had priced in. This corresponded with declines in bond values, as well as a sell-off in richly valued equities, which have a greater sensitivity to bond valuations.”

Deflation is the economic condition of inflation remaining meaningfully higher than target at the same time that economic growth is negligible or negative. 

It presents a problem for central banks because they can usually fix one or other of those problems, but not both at the same time. 

Cutting rates to stimulate growth would likely have the effect of making inflation worse, while raising rates to combat inflation would likely have the impact of reducing growth. 

Chris Beauchamp, chief market analyst at IG Group says that the Federal Reserve’s decision to pause interest rate rises, but signal that rates will stay higher for longer means that for the first time in a while, "meaningful things are happening in markets".

Beauchamp adds: "What may be different now is that bond yields have risen since the announcement, and that means some of the traditional safe haven equities in the market do not look safe.

But he feels that cyclical assets also look unattractive as rates remaining higher for longer means pressure on household budgets. 

"So when you have a situation where both the solid companies and the more cyclical companies are struggling, and stagflation moves nearer. That is upending a lot of assumptions in the market, and that is a nasty cocktail for most investors to deal with, and leaves central banks with some difficult choices to make.”

Tech rally? 

Beauchamp says he believes that one of the catalysts for the strong performance of large US technology stocks earlier in 2023 was the assumption that when rates peaked, there would only be a short period of time before they were once again cut.

Lower rates typically mean lower bond yields, and those help the investment case for “growth stocks”, which are typically defined as companies that will earn the bulk of their revenues in the future, rather than in the short-term.

If bond yields are lower, then that increases the attractiveness of future revenue from equities. 

Beauchamp said one of the effects of the recent spike in bond yields has been to send technology shares down, and in particular the shares of many of the companies associated with artificial intelligence, as these companies may be further away from those future revenues than more established technology businesses, and so are more acutely impacted.  

Nadège Dufossé, global head of multi-asset at Candriam, is a little more positive on the global economy, but still believes rates will remain higher for longer, while global growth will be below the average levels achieved in the decade prior to the pandemic.

With this in mind, she said her view is that general investor sentiment towards equities has improved this year, and this means markets are entering a period of possible economic stress at a time when valuations are not especially cheap, and so, in her view equities are a particularly high risk investment right now. 

Shamik Dhar, chief economist at BNY Mellon Investment Management is also planning for a downturn. 

He says some investors are embracing an optimistic strategy which some commentators have called “immaculate disinflation”, a scenario where central bank policy causes inflation to fall, without growth also declining. 

Dhar says: “By our estimates, recession risk remains material and is higher than what the markets are pricing in.

"While ‘recession fatigue’ from a downturn that never seems to arrive is understandable, this fatigue is not an excuse to abandon the data and adopt an investment strategy of hope. Therefore, we position to get ahead of recession impacts, rather than hope for immaculate disinflation.”

When it comes to equity allocations, his view is that while caution should prevail, he sees a greater possibility of the US achieving something close to the immaculate disinflation narrative, which would be supportive for equity markets, while he also believes the US equity market can be the beneficiary longer-term from artificial intelligence. 

When it comes to fixed income exposure, he says he favours long duration bonds, the traditional asset class to own if one anticipates a recession, long duration bonds.

He says it may be too early to own such bonds right now but he views the risk of being too late to go into long duration as exceeding the risks of being too early, and for this reason he is focusing there, while also minimising credit risk. 

Lothar Mentel, chief investment officer at Tatton, says the present economic conditions mean the US may have better economic prospects than Britain, but higher bond yields, which are worse for equities, while Britain may have worse economic prospects but lower bond yields as a result.

He says that while each of those scenarios presents challenges for investors, he does not view the coming market events as an emergency. 

David.Thorpe@ft.com